How should we fund nonprofits?

Clara MillerOctober 23, 2008

The nonprofit sector is developing tools for financing and managing the organization that come largely from the for-profit world. Clara Miller, president and CEO of the Nonprofit Finance Fund discusses both the need for more financial savvy in the nonprofit realm as well as the pitfalls of an overly commercial mindset.

Q: What is the Nonprofit Finance Fund?
We are a community-development financial institution focused on connecting finance with nonprofit success. We provide flexible debt financing to nonprofits, which we've done for 25 years, and now, increasingly, equity-type financing for nonprofits, which we're in the process of inventing. Our goal is to meet the nonprofit sector’s “whole enterprise” financial needs.

We also speak, write, and advocate for improved financing and funding practices for the sector. That is a little bit different from what most people would currently think of as good nonprofit financial practices, which largely focus on compliance and comportment. We look at how to fix the underlying business model — how to help people understand what their commercial proposition is, and to get the tools they need to be able to thrive.

Q: Could you explain the difference between debt and equity-like capital?
Debt has much more to do with evening out the timing of revenue against expense. It may help spread out the cost of the acquisition of an asset over the life of that asset (a building is a typical example), but it isn’t the permanent addition itself, which is, eventually, part of an organization’s equity. An equity investment, in the for-profit sense, helps attract more revenue to fund the enterprise, and for nonprofits that, in turn, funds mission delivery.

In some business models you might use debt to do some of the things that equity does, but that tends to be difficult for nonprofits. When you grow as a nonprofit, by expanding the core business (let’s say providing educational services to kids), you typically lose money on direct service income. In this instance it’s tuition which seldom covers the full cost of a quality education. So the more kids educated the less profitable the organization is and that doesn’t bode well for debt repayment. Thus, many times nonprofits need equity-like capital more than debt to build capacity.

Q: How are you working on this?
In the bizarre nonprofit accounting world all incoming resources are treated the same — money restricted for a capital project, bingo receipts, tuition, foundation grants, etc — all flow through the income statement. Well, so what? This way, whether you get a dollar from someone paying tuition or if you get a dollar that's focused only for bricks and mortar, they both appear as ordinary revenue on your income statement. What ends up happening is that your operating health (or lack thereof) is obscured by income that isn’t really available for operations, because our GAAP accounting rules obfuscate what's happening. In the for-profit accounting world, capital goes straight to the balance sheet.

George Overholser [founder and managing director of the NFF’s Capital Partners division] and his team have developed a GAAP-acceptable way of doing equity-like accounting for nonprofits (embraced by some major accounting firms) that lets everybody see what is actually going on.

Q: Are you drawing on models from the private sector?
George comes from venture capital. He was on the founding team of Capital One. He really has worked to adapt venture capital principles to the business realities of our sector. But if you talk to some of the folks from that world who haven't been in the nonprofit world for very long, they can't understand why nonprofits just can't get their act together and “scale up.” It is different.

It’s worth reminding everybody that there is a reason there is a nonprofit sector: we provide services to people who don't have any money to pay. It doesn't matter if you're a captain of industry, that's a tough commercial proposition to overcome. Or we do things where nobody knows what or if there might be a commercial outcome at all, like basic research scientific research. What we're trying to put together is a hybrid that doesn't make any pretense about the lack of commercial proposition for nonprofits, yet still honors the power of for-profit “enterprise finance” principles.

The organizations we do the most work with are the ones that are “too big to be small and too small to be big.” Organizations that are trying to figure out their business model. They grow from startup to about $1 million in revenue, that's approximately 10 full-time equivalent personnel. The director, little by little, can't keep the whole thing in his or her head, so the organization has to start building articulated systems and hire people with specialized tasks, where before they were generalists, i.e., everybody would answer the phone.

That stage is where growth capital starts becoming very important, because the healthy way to grow is to build systems in advance of need for them. The managers need to be able to make mistakes, like figuring out how big the subsidy business should be. Should it be individual donors or foundation grants? Should we just change our pricing model? Should we go more up-market in order to subsidize the very poor people who we want to serve?

Growth capital allows an organization the slack it needs to learn as it’s growing.

Q: How is social return on investment measured and how is it explained to equity investors?
I think this is a multi-layered question. When every organization tries to take on every layer, it can get expensive and dysfunctional. The people doing the work aren’t the ones to do big social return on investment studies. For them it should be simple, did the people we serve get what we supply? Yes. Okay, check. Did something simple—in our band of control—change? Yes, people can now (let’s say) read at a first grade level.

But there's what people call "transformation," which includes second and third order effects—i.e. “being literate means you pay more taxes.” And measuring that requires long-term, longitudinal, econometric studies. With those studies it's not so much change that’s measured. And it’s not just production, although I think that's also worth measuring. It's also things that don't happen as a result of doing what we're doing. It's the avoided taxpayer costs for the next 45 years of not having a kid who is in foster care. That can be wonderful in a big econometric sense. Even though it's very easy to demonstrate you have a reduction in expense, it's not in real time. It's much farther down the line. And that's the other piece of this nonprofit/for-profit puzzle, that nonprofit achievements with great social payoffs require long term investment. Real change and the real transformation take time.

In the financial markets it's sometimes like a gigantic commercial fire sale out there. You're either hitting your numbers or you're gone. But if we translate that over into the nonprofit sector, that can't be good, because it means we don't invest in anything that takes times — like providing a great education, or funding a cure for cancer. So it could mean that we don't invest in things that take awhile. That's another piece of the social return on investment that has to be very carefully crafted, we don't want to be measuring long-term payoff with short-term instruments.

Q: Are people from the private sector entering philanthropy, trying to apply the business world models, and running into problems?
There are some people who can really be helpful. And there are some folks who imagine that they can advise when they can't. Very enthusiastic, smart folks who don't really understand the different set of commercial assumptions try to solve for the wrong set of variables.

I was talking to a VC one day who was excited about bringing the venture capital model to the nonprofit sector, and so I said, "Okay, you've put money in to build the capacity of a program that prevents child abuse. Everyone has decided that rationally the program will be overstressed if it serves more than 100 children this year. Then the executive director takes in 10 more kids, saying, ‘They were going to be beaten up. I just couldn't say no.’” I asked the VC, "What do you do?" And he said "Same thing I'd do with a venture capital startup, just ‘put my foot on their throat’ until they change.”

With nonprofits the proposition is different. It's not just about profitability. It's about service to the world. In many cases, especially in health and social services, the greatest risk is actually borne by the people being served. So, there are moments where you have to figure out how to manage around risk to a small child. And that's not the same as risk to a stockholder.

But nonprofits do need to understand how the world of commerce and money works. Right now in the nonprofit world it's very common to have capital campaigns. And to some extent a capital campaign is like an equity campaign, except that in most cases the nonprofit sector has the funny habit of cordoning off asset classes: these funds are only for bricks and mortar, and these are for endowment. In a period of growth, that's disastrous, because it restricts cash. And cash is the primary hedge against risk.

That's something that the current nonprofit setup can take from the venture capital side of this, the notion that you need tangible, accessible cash to fund growth itself. Part of the NFF Capital Partners and equity capital idea is to help nonprofit managers understand the whole range of resources that are needed for growth.

There's a lot of talk about for-profits and nonprofits and hybrids and for-profits that do social good and all this type of stuff. Sometimes we think that’s cutting edge work. But if the fundamentals aren’t there, we’re only tinkering with tax status, and that doesn’t change an untenable business proposition. So we do a lot of kidding around about "Oh, yeah, there's another 'duh moment' for our sector." It's cutting edge, but it's also back to basics at the same time.